Question

Question:

(a) Identify and discuss two approaches to forecasting free cash flow to the firm (FCF) and free cash flow to equity (FCE)

(b) identify and discuss in detal three areas in particular where traditional DCF comes short verses option theory

Answer 1

the two approaches used to forecast FCFF and FCFE are :

1) use historical free cash flows and apply a growth rate : under the assumptions the growth rate is constant.

2) forecasting compoents of free cash flow : this relates sales growth to future capital expenditures , depreciation expense, and changes in working capital.

capital expenditures are incurred for 2 major concerns:

a. for expansion of existing capacity

b. to support growth. the first is to support current level of sales and the predicted sales growth.

THe FORMULA USED FOR CALCULATING FCFF IS :

FCFF = EBIT ( 1 - TAX RATE ) + DEP - FC INVESTMENT - WC INVESTMENT.

FCFE = NET INCOME - NET CAPITAL EXPENDITURE - CAHNGES IN WORKING CAPITAL - CAHNGES IN FIXED CAPITAL + NEW DEBT - DEBT REPAYMENT.

incremental fixed investment is fixed investment in excess of depreciation.

b )1.the traditional DCF is incompetent in dealing with uncertainties and flexibilities of various investment opportunities, whereas option analysis is a very valuable tool to formulate investment problems and strategic decisions in uncertain environment.

2.real optiosn are not only useful in valuing firms but also as a strategic busienss tool for capital investment.

for example should a firm invest billions in a new technology or should a firm invest in a new e commerce initiative are all answered by the options theory but the discounted cahs flow approach fails to answe such questions.

most of the answers to these questuons obtained by discounted cash flow appraoch is flawed because of static one time decsion making process.

3. the real options approach assumes a learning model , where management takes a more strategic and informed decision , the DCF approach is more static with only one recourse ,and without a alternative path or option in the future to take in case one method fails to generate results.